Eugene F. Fama, Robert J. Shiller and Lars Peter Hansen shared the 2013 Nobel Prize in Economic Sciences for their research on how the market prices of assets such as stocks move.
The three laureates, all Americans, “laid the foundation for the current understanding of asset prices,” the Royal Swedish Academy of Sciences, which selects the winner, said today in Stockholm. “It relies in part on fluctuations in risk and risk attitudes, and in part on behavioral biases and market frictions.”
Their work spans almost 50 years of research, beginning with Fama’s finding that it’s difficult to predict price movements in the short run, a conclusion that contributed to the development of stock-index funds. Later work by Shiller and Hansen focused on longer-run price swings and the extent to which they could be explained by such fundamental features as dividend payouts on stocks and the risk appetite of investors.
The awards are a “very interesting collection because Fama is the founder of the efficient market theory and Shiller at least is one of the critics of it,” said Robert Solow, winner of the Nobel economics prize in 1987 and professor emeritus at the Massachusetts Institute of Technology in Cambridge.
Yankees-Red Sox
“It’s like giving a prize to the Yankees and the Red Sox,” he said, comparing the competing economic theories to the rivalry between the New York and Boston baseball teams. “It was just an indication that what they were interested in was all those that had contributed to the modern theory of finance at both ends of the spectrum.”
Fama, 74, known among economists as the “father of modern finance,” is a professor at the University of Chicago. In the mid-1960s he propounded theories that argued that stock-price movements are unpredictable and follow a “random walk,” making it impossible for any investor, even a professional, to gain an advantage. He also showed in later work that so-called value and small-cap stocks have higher returns than growth stocks, and he rejected the notion that markets often produced bubbles.
“Fama’s research at the end of the 1960s and the beginning of the 1970s showed how incredibly difficult it is to beat the market, and how incredibly difficult it is to predict how share prices will develop in a day’s or a week’s time,” said Peter Englund, professor in banking at the Stockholm School of Economics and secretary of the committee that awards the Nobel Prize in Economic Sciences. “That shows that there is no point for the common person to get involved in share analysis. It’s much better to invest in a broadly composed portfolio of shares.”
Long-Run Prices
Shiller, a Yale University professor, demonstrated in the 1980s that it’s easier to predict prices over the long term, after finding that stock prices fluctuate more than changes in a company’s dividends would suggest. He showed that the same relationship holds for bonds.
The study of housing prices has been a long-standing interest of Shiller’s. Dissatisfied with existing data, he and Karl Case created the S&P/Case-Shiller home price indexes. These captured U.S. home prices doubling from 2000 to mid-2006, then plunging 35% amid the worst financial crisis since the Great Depression.
“Shiller’s research showed episodes when assets were overvalued,” said Englund. “Shiller said in the late 1990s, when IT shares rose, that this is not sustainable in the long- term, which he was right about. He also warned for many years about a housing bubble in the U.S. He was right there too.”
When he learned he’d won this year’s prize, Shiller’s reaction was one of “disbelief,” he said via telephone at a press conference in Stockholm today. “I did not expect it.”
Imperfect System
Shiller said the 2008 financial crisis “reflected mistakes and imperfections in our financial system that we are already working on correcting. I think there’s much more to be done. I think it will take decades. But we’ve been through financial crises many times in history and we generally learn from them.”
Shiller, born in Detroit in 1946, has been at the vanguard of economists chipping away at the theory of efficient markets, which argued that markets price in all available information and that investors can’t beat the market. His research showed that investors can be irrational and that assets from stocks to housing can develop into bubbles.
“Shiller found that stock prices were bad ‘weathermen,’” said Nobel laureate George Akerlof, an economics professor at the University of California at Berkeley and husband of Janet Yellen, President Barack Obama’s nominee to be Federal Reserve chairman. “Historically, they have been much more variable than the current value of the dividend streams.
Rational Expectations
“From this evidence, he concluded that rational models of the stock market, in which stock prices reflect rational expectations of future payouts, are in error. This clever combination of logic, statistics, and data implies that stock markets, are, instead, prone to irrational exuberance.”
Shiller earned his Ph.D in economics from the Massachusetts Institute of Technology in 1972. In 1981 he released a broadside against the theory of efficient markets with a paper in the American Economic Review that showed stock prices were far too volatile to reflect the future stream of earnings from the asset. The paper was titled “Do Stock Prices Move Too Much to Be Justified by Subsequent Changes in Dividends?”
In 2011, at the journal’s centennial, it declared his work one of the 20 most important papers ever published, alongside papers from other Nobel laureates like Milton Friedman, Joseph Stiglitz, Friedrich Hayek and Paul Krugman.
Milton Friedman
Hansen, 60, is one of the co-founders of the Becker Friedman Institute at the University of Chicago, which builds on the legacy of Milton Friedman.
His work explores formal implications of dynamic economic models in which decision makers face uncertain environments. The main theme of his research has been to devise and apply econometric methods that are consistent with the probabilistic framework of the economic models under investigation. His work has implications for consumption, savings investment, and asset pricing.
“The choice of having Hansen complement the two extremes of efficient markets and inefficient markets is the perfect balance between the two,” said Andrew Lo, a professor finance at MIT’s Sloan School of Management.
Hansen’s Econometrics
Hansen’s development of econometric techniques for analyzing data and asset prices allows economists to test the various theories on what drives markets, he said.
The Nobel economics prize has in the past helped laureates achieve recognition for their theories outside academic circles, often bringing them closer to policy making. Past winners include Krugman, Amartya Sen and James Tobin.
Last year’s prize was awarded to U.S. economists Alvin E. Roth and Lloyd S. Shapley for their exploration of how to make markets work more efficiently by better matching supply with demand. In 2009, Elinor Ostrom became the first woman to win when she received the prize together with Oliver Williamson for investigating the limits of markets and how organizations work.
Annual prizes for achievements in physics, chemistry, medicine, peace and literature were established in the will of Alfred Nobel, the Swedish inventor of dynamite who died in 1896, and the first prizes were handed out in 1901. The economics award was set up by Sweden’s central bank in 1968.
The official name is The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel. The money, 8 million kronor ($1.2 million), a gold medal and a diploma, will be presented to the laureates at a ceremony in Stockholm on Dec. 10, the anniversary of Nobel’s death.
Last week, Martin Karplus, Michael Levitt and Arieh Warshel were awarded the Nobel in chemistry. Francois Englert and Peter W. Higgs shared the physics honor, while James E. Rothman, Randy W. Schekman and Thomas C. Sudhof were awarded the 2013 Nobel Prize in Physiology or Medicine. The literature prize went to Alice Munro.
This year’s peace prize, awarded Oct. 11 in Oslo, went to the Organisation for the Prohibition of Chemical Weapons.
Since 2012, laureates have had to make do with 20% less in prize money than previous winners, a move the Nobel Foundation said in June last year was necessary to preserve its capital.
Today’s announcement of the economics prize marks the final award for this year.
